Passive Investing – Another Reason Why the 401 K Plan Is Not for Everyone
The Financial Services Industry (Pop Culture Finance) desperately wants you to believe that passive investing is better than active investing and 401 K providers are drinking the Kool-Aid.
As a review, there are two different types of mutual funds. A mutual fund is either a passive fund or an actively managed fund. Index mutual funds are the vehicle of choice for passive investing. They mimic different stock and bond indexes and are very low cost. They are low cost because there is no management involved. Actively managed funds are as the name implies. They are actively managed and have higher costs.
The reality is that index mutual funds out perform actively managed funds the majority of the time. So, why invest with an actively managed mutual fund when you can invest in an index fund that year in and year out will capture 99% of the gains of the market?
The trend of the 401 K market place is to dump actively managed funds and just provide index funds and target date funds. The concern is that the company will be held liable for high cost actively managed funds that don’t perform. They know that index funds will perform and they are low cost. That is a win/win for the employee -right? Well, not for everyone.
Conservative Investors Get the Bad End of that Deal
There are two types of actively managed funds. First, there are actively managed funds that try to beat the market and then there are actively managed funds that truly manage for growth and risk. They are conservatively based funds.
For those that think passive is the way to go, I agree with the notion that it makes no sense to invest into an actively managed fund that is trying to beat the market. It makes no sense for an investor to risk the performance of an actively managed fund when they can simply track the market with an index fund. For investors who want market type returns, index funds are the way to go.
I disagree with the notion that passive investing with index funds are for everyone. If 401 K plans convert their investment options to mainly index funds, what is the conservative investor going to do?
Conservative investors don’t want to take 100% market risk with their stock market investments. Conservative investors are not concerned with the cost of a mutual fund. They want less exposure to risk and grow their investments conservatively. Index funds that you will find in a 401 K plan can’t do that. During the financial crisis, most traditional index funds lost 40 to 50% where as conservative actively managed funds lost 10 to 15% and made their losses back much quicker.
So, what is a conservative investor going to do? Without options that fit conservative risk levels and especially for the company that doesn’t provide a matching contribution, it might be another reason why 401 K plans might not be a good fit at least for the conservative investor.